Kraft Heinz: More Like A Clean-Up Than A Turn-Around (NASDAQ:KHC)

Via SeekingAlpha.com

I wanted to do a quick update on Kraft Heinz (KHC). This was one of my more contentious articles when I wrote it last year. I wanted to see how my thesis played out and whether or not the situation has changed enough that there is an investment opportunity.

The price of the stock at publication of my original article was $32.63. This represented roughly the high point during the entire 1-year plus period. Like the entire market, the stock fell during the coronavirus pandemic to a low of around $20.00 – $22.00. At the current share price of $29.95, the stock is at a -8.21% loss. However, Kraft Heinz has been paying dividends to the tune of $0.40 a quarter ($2.00 for the entire 1 year plus period). Had you invested in Kraft Heinz your performance would have been more or less flat. I suppose this gives some credence to those who called the stock’s bottom at the time. Given the change in the situation worldwide due to the coronavirus pandemic and the passing of one-year I wanted to see if the stock is now worth a second look.

Kraft Heinz stock price (March 2019 – present)

Kraft Heinz had a rough 2018 with the stock taking an absolute nosedive during that year. Owners 3G Capital in years past essentially went too far with their cost-cutting measures irreparably damaging Kraft Heinz’s main asset which is its brand.

With the sole focus being cutting costs, management was not able to evolve their brands to keep up with the shifting landscape. Process food was out and healthy/organic foods were in. Its competitors were able to somewhat latch on to this trend leaving the company in the dust. The company was carrying a huge amount of debt as well limiting its strategic options and investments it could make.

Management moves to turn things around

Initially, the common thought was that the best way forward is to start reducing the debt load by selling some of the companies assets. The company wanted to sell off its Maxwell House brand of coffee for $2.5 billion and its Ore-Ida potato business for $2 billion.

I thought this was a bad idea as 1) it was a fire-sale situation, 2) it will weaken the company’s long-term earnings, and 3) it would only slightly reduce the scale of the debt. On a financial ratio basis, if the company did not get a good price, the balance sheet would have been worse-off. Ultimately, management did not end up selling these brands or other core assets. The main sticking point being the fetching price. In this case, I applaud management for sticking to their assessed value of these brands and not accepting anything less than that.

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Looking through the disclosures of the company there was no major divestiture in 2019 with the exception of the sale of the Canada natural cheese business for $1.2 billion. This deal was done during 2018 though and only closed in 2019.

Kraft Heinz has been going through an organizational transformation. The company decided the way forward was to try to fix its business rather than sell its underlying assets. The first step is to overhaul the management and get the right people on board. The second is to clean up the supply chain and procurement. And finally to optimize the SKUs of the company and see which products are doing well and where to allocate the company’s limited funds.

I want to examine the results from 2019 as this represents what management was actually done to turn-around the business. Current Q1 2020 results have been skewed by the coronavirus pandemic (though could still have long-term implications). Organic net sales in 2019 declined slightly by -1.7% from $25.4 billion to $25.0 billion. Organic net sales removes the effects of the company’s divestiture. This slight decline was broad-based among all product categories and all countries.

Company 10-K

The company is now only reaching a stage where they can try to fix the issues preventing top-line growth namely its brand image and new product innovation. Buried within the notes to SG&A, Kraft Heinz disclosed advertising expenses of $534 million in 2019. This is a decline from $584 million in 2018 and $629 million in 2017. Research and development costs for the company were flat as well at $112 million in 2019 compared to $109 million in 2018, and $93 million in 2017.

What this tells me is that basically the company is still in “clean-up” mode trying to fix its supply chain and operations. The company hasn’t even begun implementing a plan to increase sales and drive new product innovations. The company can talk all it wants about the strength of its brand and product innovations but we can see in the numbers that they have not actually increased spending in these areas. The company postponed its investor day where it was to present to investors its long-term strategic plans to revitalize the business. I fear that the longer this takes the more Kraft Heinz will lag its competitors.

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Company 10-K

It only took a worldwide pandemic to turn this around

The company had a fantastic Q1 2020 partly due to the effects of the coronavirus pandemic. Organic Net Sales were up 6.2% compared to a year ago. With people stocking up in the initial stages of the pandemic this was not too surprising. Furthermore, with dwindling supplies, I would wager that most customers just grabbed whatever they could. For example, if your favorite brand of Mac & Cheese is Annie’s but the only thing left on the shelf was Kraft Heinz then you’d pretty much bite the bullet in that situation. So I would wager, that whichever brand had the most available in stock at the time probably sold the most. It was an unusual situation where brand and price considerations were probably not as important. So this tells us nothing about the current state of Kraft Heinz’s brands and whether or not this bump up in sales was a one-time benefit due to the pandemic.

Coronavirus hoarding – Empty shelves picture

Investor presentation 2020

This could be the start of a new growth trend for Kraft Heinz though as countless number of people may have discovered or re-discovered the company’s brands. Furthermore, Kraft Heinz products are cheaper compared to the healthier organic options that were popular these last few years. Given that the US is heading into possibly a long recession, the company could see increased sales as people attempt to tighten their belts.

Is Kraft Heinz actually cheap?

Given that we have seen earnings stabilize in 2019, it’s fair to use this as a starting point for the valuation. In 2019 EPS was $1.56 giving at 19x P/E ratio at the current share price of $29.95. A lot of analysts are expecting a blockbuster year for the company thus forward earnings expectations are $2.33 implying a forward P/E of 13x. This isn’t exactly cheap but not expensive either.

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Cash flow from operations in 2019 was $3.5 billion an increase from $2.6 billion in 2018. This can probably be attributed to the operational efficiencies the company has been making. As of Q1 2020, the company’s cash is at $5.4 billion however long-term debt remains high at $32.7 billion. This implies that at the current state of operations it will take Kraft Heinz close to a decade to pay down this debt. However, given the present coronavirus related tailwinds and the fact that the business seems to have stabilized in 2019, this isn’t as big an issue as it was a year ago. Moody’s also recently revised the company’s outlook from “negative” to “stable”. The company is still investment grade so it should be relatively easy to roll-over its debt.

Author calculations using data from Seeking Alpha

As seen in the table above, Kraft Heinz is trading at a discount relative to its peers. However, the main question to ask is if this discount is worth the additional risks assumed. While it is worth commending the current management team, in my opinion, Kraft Heinz is still in the easy part of its turn-around namely fixing up its operations. It hasn’t begun the hard work necessary to re-build its brands to be top of mind for consumers nor has it began investing in new product innovations necessary for the future of the business. Is the extra 2% yield enough of an incentive to choose Kraft Heinz over a company like Coke or Pepsi? I think not. The stock remains an avoid for me.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.